NEW YORK, July 16 (Reuters) - U.S. homebuilder confidence rose in July to its strongest level in 7-1/2 years as tightening supply and solid demand even in the face of rising mortgage rates fueled the sector’s recovery, data from the National Association of Home Builders released on Tuesday showed.

The NAHB/Wells Fargo Housing Market index rose to 57, its highest level since January 2006, from a revised 51 in June.

Analysts polled by Reuters had projected the index likely held at its originally reported June level of 52.

Readings above 50 mean more builders view market conditions as favorable than poor. Last month was the first time that the index, which is seen as a proxy on future home construction, has been above that dividing line since April 2006.

“Today’s report is particularly encouraging in that it shows improvement in builder confidence across every region as well as solid gains in current sales conditions, traffic of prospective buyers and sales expectations for the next six months,” NAHB chairman Rick Judson said in a statement.

The government will release its June report on housing starts on Wednesday at 8:30 a.m. (1230 GMT). Economists forecast home construction likely grew at an annualized pace of 959,000 units last month, faster than May’s 914,000 unit rate and which would be its quickest pace since March.

But Judson cautioned proposed changes to mortgage interest deduction and federal support for the housing finance system might disrupt the housing recovery.

Still the housing sector, along with the labor market, has gained traction in recent months. They have enhanced the chances the Federal Reserve might reduce its bond-purchase stimulus later this year, even though some economists said the overall economy is too fragile for the central bank to make such a move.

The survey’s index on homebuilders’ view on current sales conditions rose 5 points to 60 points, its highest level since early 2006, the industry group said.

Homebuilders felt even more optimistic for the coming months with the gauge of expectations for single-family home sales for the next six months accelerating to 67 from a revised 60, while the component on prospective buyer traffic increased 5 points to 45. Both sub-indexes strengthened to levels not seen since late 2005.

“Builders are seeing more motivated buyers coming through their doors as the inventory of existing homes for sale continues to tighten,” NAHB Chief Economist David Crowe said in a statement. “Meanwhile, as the infrastructure that supplies home building returns, some previously sky-rocketing building material costs have begun to soften.” (Editing by Chizu Nomiyama)